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What’s one or two percentage points in a five-, six- or seven-figure portfolio?
That’s a very good question.
If you’re like many investors, you try not to think about fees. Either you’re convinced that a fee of one or two percent amounts to just a pittance against all the compounded gains the fund will rack up, or you’re afraid to know the total, accumulated cost of a fund you hold until retirement.
The truth is that 1) fee structures can be hard to understand, and 2) they can add up.
Consider a fee of one percent.
The simple way to consider that cost is that it shaves a percentage point off your returns. An eight percent return becomes a seven percent return. But going from 8% to 7% actually reflects a loss of 12.5% of your gains. Now apply that percentage to an actual number, say $10,000 to offer a simple example. The $10,000 you’ve earned becomes $8,750 after fees. And if you make more you pay more.
As noted, that’s an overly simple example. In reality, both the 1% and the 12.5% figures are somewhat imperfect measures of the fund’s actual cost because both fail to accurately capture the cost against the life that you hold the fund. Any fund’s performance will vary over time and many funds will have down years, making it quite difficult to measure the cost over time. One of the reasons some funds get away with charging so much is because fee structures are so confusing that even many sophisticated investors give up trying to understand them.
And while it’s difficult enough to calculate the total cost of fees and the end of the fund’s life, it’s pretty much impossible to assess this at the time of purchase. Still, there’s a lot you can do to be aware of costs.
Tips on Protecting Your Retirement Funds and Reducing Fees
Remember that fees are the cost you are paying for a service. Too often the discussion of fund fees overlooks this basic point. While it’s perfectly legitimate to ask if you are paying a fund manager too much, keep in mind that you are paying for a service, and a rather complicated one at that. Unless you think you have the skills to replicate what the fund is doing, don’t consider the money spent on fees as a pure loss. If a fund that charges a hefty 2% fee is earning you twice as much as one that charges a quarter of a percentage point, it would be money well spent. But…
Don’t assume higher fees mean larger gains. While some fund fees are worth every dollar they charge you, others just aren’t. No one has ever established a clear correlation between the cost of the fund and the performance. Successful funds do develop a high profile, which may enable them to charge more, but it’s a very inexact science. As an individual investor you may not have the skills of a fund manager, but you do have the responsibility of tracking your costs. Educate yourself about the fees you are paying and compare how your funds are doing.
Take the long view. Like stock markets, individual funds will have good years and not-so-good years. There’s no simple way to measure the actual amount you’ll pay over time, but for starters it’s important to know the funds track record over time. This is especially important when investing for retirement since you’re likely to hold the investment for a long time. Anyone can have a good year in a strong market. Don’t go on reputation alone. Make sure you know how the fund fared in the last bear market too.
Look beyond the load. Load funds are usually not no-cost funds. Remember, managing a fund is like running a business, and that inevitably involves costs. If you are going to the trouble of reviewing these costs – and you should – know all the fees including redemption fees, exchange fees and account fees. A cost by any other name is still a fee.
Revisit your choices. Because of the imprecise nature of fees over time, it’s important that you check in with funds to understand if the investment you once considered worth the high cost is performing to expectation. When investing for the long haul, it’s usually not wise to summarily dump investments because of an off year. But you need to be informed enough that you understand what you’re paying for … and whether it’s worth the price.
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